To some people, leverage trading can be dangerous because of loss amplification. However, to some people, it can be perfect because it increases investors’ buying power with less cash. Using leverage in trading enables investors to expand the size of their positions, which may increase the potential for profits.
This guide will explain everything you need to understand about leverage trading and the steps of getting started.
Understanding the basics of Leverage trading
Borrowing money from a broker to enhance the size of your position to make more returns is known as “leveraged trading.” Leverage trading is used by traders attempting to increase exposure in the market beyond their deposit.
After the leverage position is closed, the broker gets backs the capital, and the gain made by the trader during the duration is passed to the trader. Additionally, as stated in the introductory part of the content, while there is a tremendous potential for profits, there is also a greater possibility of losses.
It is common practice to express leverage as a ratio, such as 1:10 or 1:5. Aside from using ratio, it can be written as a multiple, e.g., 3x, 5x, 7x, 15x, or even 100x. This translates to the fact that: if you deposited $100, you have $10,000 to trade with.
Practical examples of Leverage Trading
Suppose gold is currently selling at $1,200, and a retail trader projects future growth; the retail trader will attempt to open a position that will maximize the gains that can be made from the price increase. A leverage of 1:5 is provided by the broker, which means traders can borrow up to 5 times the amount of their initial deposit. This means that with a $2,000 deposit, they can start a position with a value of up to $10,000.
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If the trader waits until the price reaches $1,250 before selling, they will have made a profit of $416. A cash-only position would have resulted in a profit of only $75 for the trader if they had opened the position.
Many brokers give free leverage trading calculators that may assist investors in determining how much profit they can make from their respective trades.
Going head to head: Leverage Trading vs. Spot Trading (non-leveraged trading)
The puzzle of determining whether to engage in spot trading or leverage trading is frequently faced by traders. Spot trading occurs when a trader opens a position at the present price and must hold the entire cash balance before the position expires. This type of trading is riskier than other forms of trading. If a trader doesn’t meet the financial requirement, entering that position is impossible.
Since you can only trade with the funds you now have available, spot trading carries a reduced level of risk. Because using leverage to trade entails borrowing money to create a position, the risk of losing more than your initial investment is possible. However, the most significant disadvantage of spot trading is that it restricts your potential profits to the available funds. When deciding between trading with leverage and trading spot, it is essential to strike a balance between the amount of money you can afford to lose, risk level, and trading expertise.
Leverage Trading Markets
Trading using leverage is possible in all of the most common types of financial assets. Financial assets can be Crypto, Forex, stocks, and lots more.
It is essential to add that the amount of leverage will vary depending on the regulatory constraints in place or the degree to which the asset is volatile. For instance, most authorities will allow you to use a leverage ratio of up to 1:30 when you trade forex. Conversely, cryptocurrencies are highly volatile, and as a result, they are subject to significantly lower limits, typically in the range of 1:2 or 1:3. Trading stocks with a leverage of up to around 1:5 is typically allowed.
The Benefits (Pros) of Using Leverage in Trading
- Protection against negative balances
- Provided through a multitude of regulated platforms
- Compatible with a wide variety of trading techniques
- Access to stocks with a higher value.
- Heightened chance for financial gain
- Increased visibility within the market
Negative Aspects (Cons) Of Leverage Trading
- Can cause losses that are greater than the initial amount of accessible money
- There are rules and laws about taxes that apply to profits.
- Retail traders are subject to leverage restrictions.
- Interest and fees can cancel out any gains.
- Unpredictable results
Leverage Regulations
Local legislation dictates the maximum leverage that regulated brokers are permitted to make available to their clients. These restrictions are designed to shield customers from the possibility of suffering significant financial setbacks.
- In the United States of America, leverage and margin rate is regulated by the National Futures Association regulates leverage and margin rates. The maximum leverage that may be used when trading forex is 1:50. In contrast, the maximum leverage that can be used when trading stocks is 1:4. Kraken, Coinbase, and Binance exchanges that can do crypto leverage trading. On Kraken, leverage is 1:5, and trading fees are less than 0.26% of the total trade value.
- The maximum leverage for forex trading has just been reduced by the Australian Securities and Investments Commission (ASIC) from 1:500 to 1:30. The maximum leverage for minor and exotic trading pairs has been decreased to 1:10. For shares, the maximum ratio is 1:5, while for crypto assets, the maximum ratio is 1:2.
- Since August 2021, all brokerages in India have been required by the Securities and Exchange Board of India (SEBI) to discontinue providing intraday leveraged products. Due to this limitation, day traders will only be permitted to engage in spot trades, which require them to use the funds they currently possess.
- The Financial Conduct Authority (FCA) and the European Securities and Markets Authority (ESMA) have set a leverage limit of 1:30 for foreign exchange, 1:20 for equities and indices, and 1:2 for cryptocurrencies in the United Kingdom and throughout Europe. Notably, the FCA has outlawed the purchase of bitcoin derivatives, including options, futures, and contracts for difference by regular UK traders (CFDs).
- The maximum leverage allowed for trading foreign currencies has been decreased by the Monetary Authority of Singapore (MAS) from 1:50 to 1:20 in 2019. In Singapore, cryptocurrencies are not subject to any regulation and are not recognized securities or generally accepted currency.
Strategies for Leverage Trading
To get the best from leverage trading, you will need to choose a strategy that will assist you in mitigating risk and increasing the possibility of making a profit. Below you’ll find a list that contains some of the most widely used strategies.
Swing trading strategy
Swing traders seek to profit from price changes in the short to medium term, which can be as little as one day or as long as weeks. Leverage can help achieve the goal of capturing more significant price swings than are possible in the intraday time frame, which is the focus of this strategy. On the other hand, overnight positions leave you vulnerable to the possibility of price gaps being caused by news events that occur when the markets are closed, and you cannot leave the position.
Day trading strategy
Day traders invest in assets and then immediately sell those assets on the same trading day. It is usual practice to employ a high level of leverage because price changes over a short period are likely to be minimal. Day traders also have the potential to reduce their exposure to the overnight (rollover) costs that are incurred whenever a position is held after regular business hours.
Scalp trading strategy
Scalping is a trading strategy that includes making many trades and maintaining each position open for a few minutes. The goal is to profit from minor changes in intraday prices but to do so frequently enough that the rewards add up. Scalpers often use leverage to magnify even the smallest price changes. Scalping involves commitment, huge capital, and appropriate training.
Professional Leverage training
Regulation regulations limit retail traders; conversely, professional trading accounts frequently provide access to additional perks, one of which is increased leverage. Although different brokers have varying requirements to meet to open a pro account, anyone might be qualified.
In most cases, traders are required to demonstrate sufficient levels of professional expertise via examinations or interviews. To qualify as a professional client of IG, you must have spent a minimum of a year employed in the financial industry in a position that required trading expertise. In addition, it is essential to have a diversified portfolio of financial assets such as stocks, FX, and mutual funds. To work with particular brokers, you must demonstrate that you have at least $500,000 in liquid assets. Additionally, you may be required to show a high activity level by verifying that you have executed several deals of a large amount in the most recent year. For instance, JFD Bank necessitates that traders have closed an average of 10 positions per quarter over the preceding calendar year.
Although professional accounts are rewarded with fewer restrictions, retail traders no longer have the previously available protection. This includes protection against negative balances as well as compensation for them.
Note: Ensure you are aware of both the benefits and the drawbacks of having a professional account before you apply for one.
How to Get Started with Leverage Trading
- Pick A Broker: When looking for a broker who offers leverage, consider the asset to invest in, fees, account advantages, and regulatory requirements.
- Create a new account: After deciding on a broker, set up an account and check for eligibility for a professional trading account to gain access to bigger leverage if necessary.
- Practice: Use a demo account to familiarize yourself with the platform and make navigation easier.
- Commence trading: After identifying a potential opportunity, you may place your trades and select appropriate leverage. Use a risk, liquidation, or profit calculator to assist you. Both BitMex and Binance have a variety of cryptocurrency calculators, which can be utilized to help with the management of trades.
- Close positions: After you have finished monitoring and closing your positions, your broker will deduct any debts from the capital you owe, and you will get your profit.
Going head to head: OTC vs. Exchange Leverage Trading
Both over-the-counter (OTC) leverage trading or exchange trading markets facilitate the buying and selling of securities, but their underlying structures are distinct, and each has its own set of advantages and disadvantages.
Over-The-Counter (OTC)
OTC markets are informal or “decentralized” (DEX) markets in which participants exchange assets like Forex and stocks directly with a network of one or more dealers. While fewer regulations make it possible to pursue a wider variety of opportunities, this results in a less transparent trading environment. Market-makers in the over-the-counter (OTC) market are referred to as dealers. They communicate with participants through phone or email to negotiate execution pricing and quote prices they are willing to buy (ask) or sell (bid). It is important to note that the prices quoted to customers do not always remain consistent; this indicates that markets are not being handled fairly. The absence of buyers and sellers in OTC marketplaces contributes to significant market liquidity swings.
Exchange
A centralized market for trading financial products is known as an exchange. Examples of exchanges are the New York Stock Exchange (NYSE) and the International Securities Exchange (ISE). The most distinguishing feature of an exchange is that it imposes regulations that control trade and information to maintain an atmosphere that is both fair and well-organized. It also centralized the reporting of bid and ask prices, making it transparent. For a company to trade, it must meet requirements like reporting financial information and audits and minimum capital requirements.
The bottom line
This comprehensive guide has discussed leverage trading and the associated dangers that come along with it. Leverage trading can be a blessing (if done well) or a problem (if not done well). Be sure to familiarise yourself with the fundamentals and gain experience with a demo account before you trade using leverage.
